Stockton is one of three California cities to file for bankruptcy this year.

Photo: Michael Macor, The Chronicle

Stockton is one of three California cities to file for bankruptcy...

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SAN BERNARDINO, CA - JULY 12: A plaza next to the San Bernardino City Hall is closed to entry on July 12, 2012 in San Bernardino, California. The San Bernardino City Council voted this week to file for Chapter 9 bankruptcy protection, making San Bernardino the second largest municipality in the nation ever to file for bankruptcy and the third in California to opt for bankruptcy in the past two weeks. Stockton, California with a population of nearly 300,000, became the biggest when it filed for bankruptcy on July 3. The Sierra Nevada Mountains ski town of Mammoth Lakes, California also voted for bankruptcy July 3. The city is facing a $45.8 million budget shortfall and is in danger of not making payroll for the next three months. City officials are set to discuss the next steps in the bankruptcy process and may also declare a fiscal emergency at its meeting July 16. (Photo by David McNew/Getty Images)

For the second time in as many business days, a major credit-rating agency said it expects more municipal bankruptcies and bond defaults - particularly in California, where cities have less flexibility to raise revenue or cut spending and face little intervention from the state.

On Monday, Fitch Ratings said in a report that it "anticipates an increase in defaults and bankruptcies, although it does not expect them to be widespread."

It said that recent bankruptcy filings by Stockton, San Bernardino and Mammoth Lakes "reflect perhaps the most difficult local government fiscal environment in the U.S.," adding that "fiscal crises are more likely in states that, like California, lack flexibility on both revenue raising and spending control."

In a similar report Friday, Moody's Investors service said it expects "more bankruptcy filings and bond defaults among California cities" and is considering "across the board adjustments of debt ratings for California cities to reflect the new fiscal realities and the governmental practices in addressing them."

Tom Dresslar, a spokesman for the California treasurer's office, said "recent developments merit concern," but the fact that three California cities out of 482 have declared bankruptcy this year "is not evidence of a looming stampede into bankruptcy court."

Causes for concern

In their reports, Moody's and Fitch cited reasons why they believe California cities will continue to face fiscal pressure:

-- California, especially the Inland Empire, has been clobbered by the housing crisis, which has reduced property tax revenue. But unlike other hard-hit states such as Florida, local governments can't offset falling property tax values by raising the tax rate because of Proposition 13.

-- The weak economy has reduced sales taxes, another important revenue source for cities.

-- The state's pro-labor stance makes it harder for cities to renegotiate employee pay and benefits, which typically account for two-thirds of municipal budgets but can reach 80 percent, Fitch said.

Fitch notes that 23 states do not require employees to join and pay dues to established unions as a condition of employment. California is not one of these right-to-work states.

Moody's also said that "generous labor contracts awarded in boom times have proven hard to reverse" in California.

-- State government has done little to prevent cities from filing bankruptcy.

California "has had a strong tradition of local government 'home rule,' meaning that the state has not taken a strong interventionist approach to addressing the fiscal problems of local governments," Moody's said.

"Not since the state support after the passage of Proposition 13 to replace a substantial portion of local governments' lost property tax revenues has the state been willing to provide cities with additional financial aid."

It noted that states such as New York, Michigan, Rhode Island and Pennsylvania have provided struggling cities with financial or technical assistance, oversight boards or, in extreme cases, outright takeovers.

"By contrast, in California, the state's view is that it has given city and county governments the tools to address these problems by themselves."

Dresslar said the treasurer's office "is in the very early stage of an initiative aimed at trying to devise a system in California that would identify early on cities that are undergoing significant financial stress and help them address those problems without default or bankruptcy."

-- Cities cannot file bankruptcy unless their state allows it. California is one of 28 states that permit it. However, after Vallejo's bankruptcy, the state passed AB506, which requires cities to negotiate with creditors for 60 to 90 days before filing for bankruptcy. A city can bypass this step by declaring a fiscal emergency.

Fitch said the law "does not appear to have reduced the likelihood of bond default or municipal bankruptcy." Moody's says it might even encourage bond defaults.

"The law's explicit instruction to negotiate with creditors, including bondholders, appears to condone, if not normalize, less than full and timely payment to bondholders," it said.

Differing solutions

It's not surprising that bondholders would like struggling cities to balance their budgets by cutting employee and other costs while employees want bondholders to share in the pain.

"The bottom line is that it's not fair to scapegoat public employees and pensions for the financial woes of our cities or of our entire state for that matter," Rob Feckner, president of the California Public Employees' Retirement System, wrote in a commentary in the Sacramento Bee this month.

"The real culprit is the economy and housing market, along with financial decisions made by city officials," wrote Feckner, who is also a vice president with the California Labor Federation.

The three of bankruptcies has done little to dampen demand for California municipal bonds. They have been a popular investment this year, mainly because they yield slightly more than U.S. Treasury bonds and investors are desperate for income.

Matt Fabian, a managing director with Municipal Market Advisors, said investors should expect to see growing ratings differences between safer and riskier bonds, depending on the bond's structure and issuer.

'Wave of downgrades'?

Moody's said it is considering downgrades "for particularly economically and fiscally distressed California localities, including counties, school districts, and special districts," plus additional downgrades for bonds other than general obligation and special tax bonds.

"You could see a wave of downgrades for less well-secured securities, which is frankly justified," Fabian says.

"It's important that investors make state-by-state differentiations between bond structure and (the issuer's) willingness to pay. These things need to be factored more heavily into the market."